Full Explanation of Margin
Margin is a very widely used word in financial terms, but it's unfortunately a word that is often very confusing for people. This is largely because it has a number of different meanings, depending on what context it is being used in. In particular, the meaning of the term as used in options trading is very different to the meaning of the term as used in stock trading.
The phrase profit margin is also a common term, and that means something else again. On this page we explain what the term margin means in these different contexts, and provide details of how it's used in options trading.
- Profit Margin
- Margin in Stock Trading
- Margin in Futures Trading
- in Options Trading
- Standard Portfolio Analysis of Risk
Profit margin is a term that is commonly used in a financial sense in a variety of different situations. The simplest definition of the term is that it's the difference between income and costs and there are actually two types of profit margin: gross and net.
Gross profit margin is income or revenue minus the direct costs of making that income or revenue. For example, for a company that makes and sells a product, their gross profit margin will be the amount of revenue they receive for selling the product minus the costs of making that product. Their net margin is income or revenue minus the direct costs and the indirect costs.
Investors and traders can also use the term profit margin to describe the amount of money made on any particular investment. For example, if an investor buys stocks and later sells those stocks at a profit, their gross margin would be the difference between what they sold at and what they bought at. Their net margin would be that difference minus the costs involved of making the trades.
Profit margin can be expressed as either a percentage or an actual amount. For example, if you made $10 profit from a $100 investment your profit margin would be $10 or 10%.
Margin in Stock Trading
You may hear people refer to buying stocks on margin, and this is basically borrowing money from your broker to buy more stocks. If you have a margin account with your stock broker, then you will be able to buy more stocks worth more money than you actually have in your account. For example, if you have $10,000 in your account, then you may be able to buy up to $20,000 worth of stock.
If you do buy stocks in this manner and they go down in value, then you may be subject to a margin call, which means you must add more funds into your account to reduce your borrowings. Margin is essentially a loan from your broker and you will be liable for interest on that loan. The idea of buying stocks using this technique is that the profits you can make from buying the additional stocks should be greater than the cost of borrowing the money. You can also use margin in stock trading to short sell stocks.
Margin in Futures Trading
Margin in futures trading is different from in stock trading; it's an amount of money that you must put into your brokerage account in order to fulfill any obligations that you may incur through trading futures contracts. This is required because, if a futures trade goes wrong for you, your broker needs money on hand to be able to cover your losses.
Your position on futures contracts is updated at the end of the day, and you may be required to add additional funds to your account if your position is moving against you. The first sum of money you put in your account to cover your position is known as the initial margin, and any subsequent funds you have to add is known as the maintenance margin.
Margin in Options Trading
In options trading, margin is very similar to what it means in futures trading because it's also an amount of money that you must put into your account with your broker. This money is required when you write contracts, to cover any potential liability you may incur. This is because whenever you write contracts you are essentially exposed to unlimited risk.
For example, when you write call options on an underlying stock you may be required to sell that stock to the holder of those contracts. Assuming that you don’t own the necessary stock, you would then have to purchase it from the open market at whatever price it happened to be trading at. If it was trading at a significantly higher price than the strike price of the contracts you had written, then you would stand to lose large sums of money.
In order to ensure that you are able to cover that loss, you must have a certain amount of money in your trading account. This allows brokers to limit their risk when they allow account holders to write options because when contracts are exercised and the writer of those contracts is unable to fulfill their obligations, it's the broker with whom they wrote them that is liable.
Although there are guidelines set for brokers as to the level of margin they should take, it's actually down to the brokers themselves to decide. Because of this, the funds required to write contracts may vary from one broker to another, and they may also vary depend on your trading level. However, unlike the requirements when trading futures, the requirement is always set as a fixed percentage and it isn't a variable that can change depending on how the market performs.
It's actually possible to write options contracts without the need for a margin, and there are a number of ways in which you can do this. Essentially you need to have some alternative form of protection against any potential losses you might incur. For example, if you wrote call options on an underlying stock and you actually owned that underlying stock, then there would be no need for any margin.
This is because if the underlying stock went up in value and the contracts were exercised you would be able to simply sell the holder of the contracts the stock that you already owned. Although you would obviously be selling the stock at a price below the market value, there is no direct cash loss involved when the contracts are exercised. You could also write put options without the need for a margin if you held a short position on the relevant underlying security.
It's also possible to avoid the need for a margin when writing options by using debit spreads. When you create a debit spread, you would usually be buying in the money options and then writing cheaper out of the money options to recover some of the costs of doing so. For example, you could buy call options on Company X stock with a strike price of $20 and then write call options on Company X stock with a higher strike price. Assuming you buy the same amount of contracts as you write, your losses are limited and there is therefore no need for margin.
There are a number of trading strategies that involve the use of debit spreads, which means there are plenty of ways to trade without the need for margin. However, if you are planning on writing options that aren't protected by another position then you need to be prepared to deposit the required amount of margin with your options broker.
Standard Portfolio Analysis of Risk
The Standard Portfolio Analysis of Risk, known as SPAN, is a method used for working out the margin requirements for futures, and futures options. Unless you are trading using futures options, then this will have absolutely no bearing on you because it doesn’t apply to other types of options such as stock options or index options. In reality, even if you are trading futures options this isn't something you really need to concern yourself with. However, you may hear the term used and it can be useful to know what it is.
The SPAN system was developed by the Chicago Mercantile Exchange in 1988, and is basically an algorithm that's used to determine the margin requirements that brokers should be asking for based on the likely maximum losses that a portfolio might incur. SPAN calculates this by processing the gains and losses that might be made under various market conditions. As we have mentioned, it's far from essential that you understand SPAN and how it's calculated, but if you do trade futures options then the amount of margin your broker will require will be based on the SPAN system.